The term “dilutive” is primarily utilized within the financial sector, especially in relation to investments, securities, and corporate finance. It is associated with anything that diminishes the financial strength or value of an asset or company. Basically, it refers to a decrease in earnings per share of a company’s stock due to the issuance of additional shares or the conversion of convertible securities.
To understand the concept of dilution in finance, think about a large jug of concentrated juice. If water is added to this juice, it becomes diluted, meaning the flavor of the juice is less intense. This is exactly what happens when a company issues more shares of its stock. The value of each share is reduced, and therefore, the ownership stake of each shareholder is diluted. This means the earnings per share (EPS) also get reduced because the net income of the company is distributed among a greater number of shares.
Convertible securities, such as convertible bonds or convertible preferred stock, can also result in dilution. Convertible securities are financial instruments that can be converted into common stocks at some future date. When these convertible securities are converted into common stock, the number of total outstanding shares increases leading to dilution.
So, why would a company choose to dilute its shares knowing that it reduces the value of each share? One primary reason is to raise capital or fund expansionary projects. Money generated from selling more shares can be used for multiple business purposes such as paying off debt, investing in research and development, or acquiring another company.
The degree to which a transaction is dilutive depends on the ‘relative’ price paid and the incremental earnings generated. Dilution can negatively impact the ownership percent and voting control for existing investors. However, if the company utilizes the raised capital efficiently, the long-term result can still be beneficial.
Keep in mind that while dilution often carries a negative connotation because it can decrease the value of an investor’s shares, it is not always detrimental. If the money generated from issuing new shares is used effectively, it can lead to growth in the company and eventually bring about an increase in the share price.
In conclusion, the term “dilutive” expresses the decrease in the value of a company’s shares due to the issuance of more shares or the conversion of convertible securities. However, the concepts and implications of dilution are complex and depend on several factors, making it vital for investors to thoroughly understand this term and its potential impact on their investments. Being knowledgeable about such concepts can help make more informed investment decisions.